"The future of the regional insurance companies"

Seminar Report - by Frank Lierman

This SUERF seminar, jointly organised with the Grazer Wechselseitige (GRAWE), took place in the Graz branch of the Oesterreichische Nationalbank and was attended by more than 40 people.

Eduard Hochreiter, General Secretary of SUERF, opened the seminar with a description of SUERF’s mission statement and activities. He appreciated strongly the co operation with the Grazer Wechselseitige. He chaired the session with the two keynote speakers.

Andreas Grünbichler, Executive Director of the Austrian Financial Market Authority, focused on the "Regionalisation and Europeanisation of Financial Markets – A challenge for Industry and Supervision". Stock market performance of insurance companies in Europe in recent years has been disappointing after strong progress in the second half of the nineties. 9/11 has had an enormous impact, with the extremely low interest rates also being a real handicap. Insurance company volatility has been much higher than for banks or financial services. The same is true for the average returns. He examined the structure and evolution of the insurance market in the OECD, the European Union, the 10 accession countries and Austria. Austria’s insurance activity is not strongly developed. Direct gross premiums per GDP are very low and relatively close to those of the Central European countries. Deconcentration is occurring in Slovakia, the Czech Republic and Poland, while concentration is occurs in others. In Poland, Hungary and Estonia, there is a strong presence of subsidiaries of EU companies. Austrian insurance companies such as Wiener Städtische, Generali, Grawe and Sparkassen Versicherung are quite well represented in Central European countries. A Boston Consulting Group has shown Austrian insurance companies to be mainly national or regional players, with only two really being international companies. The bank-insurance formula is strongly developed in Sweden, the United Kingdom, Italy and France.

Grünbichler then focussed on supervision aspects with special attention for the Financial Services Action Plan. The FSAP’s goal is to improve the Single Market, with 36 of the proposed 43 measures already in place, and priorities and a time frame given for specific actions. The strategic goals are to create a single EU Wholesale Market, to open up the retail markets and to fix the state of the art of prudential rules and supervision. Directives must be transformed into national laws. This is certainly the case for directives concerning financial conglomerates, insurance mediation and transparency, with specific directives in preparation for reinsurance, rating agencies, corporate governance and supervision of auditors.

Andreas Grünbichler also commented upon the comitology layout within the Lamfalussy scheme for banks and insurance companies. The measures vis-à-vis single market insurance companies are linked to the principle of the single licence obtained within the home country. The host country authority has no veto. If an infringement of the host country regulation occurs, a request to restore the proper state is needed. If the insurer is not compliant, information must be given by the home country authority. If none or insufficient measures are taken, the host country authority may act (even an interdiction of business). If the interests of policyholders are jeopardised, direct action is possible.

Schemes

The aims of the supervision of financial conglomerates are:
- to avoid double gearing and excessive leveraging,
- to define the scope of risk within a group,
- to control different solvency requirements and risk structure across sectors,
- cross-sectorial supervision
- the contagion theme.
The consolidated supervision aims the solvency of conglomerates, the fixing of adequate risk management and internal control procedures for intra-group transactions and risk concentration, the designation of a co-ordinator for cross-border supervision and the fixing of fit and proper requirements for management.

Dr. Laszlo Asztalos, president of the Tolerancia Financial Consultancy Ltd. & Association of Hungarian Insurance Consultants developed his intervention on "Some Historico-Philosophical Components of an EU-accessing Insurance Industry".

The Eastern European countries belong to the third speed-Europe zone. They are in the same competition as the old EU members but they start from 30-50-70 years behind. The rules are uniform. The rigidity is equal. The consequences are enormous. The time of special observations and tolerance for insurance companies is over. The European "per-unit" thinking of way becomes the standard for the evaluation of the performances of the companies. There is only one real successful protective tactic: the so-called two-digit profitability. Is that goal a realistic one? In the last 25 years more than half of the Hungarian insurance companies have been fulfilling the norm of two-digit profitability. But recently the performances are poorer due to the necessary restructuring of the economy and the social security system, the restrictive monetary decisions, the cutting of fiscal package, restructuring of health care, pension, education, etc. It is quite impossible to combine budget deficit, des-inflationary monetary policy, adjustment of balance of payment and employment-supporting exchange rate. Governments must choose.

In Hungary in 2003 people have been learning how a failed financial policy-mix with a revaluated exchange rate could consummate quite all the profits of the exports, which is not far from 60 % of GDP. In 2004 Hungary has experienced how could another type of failed financial policy-mix with a devaluated exchange rate consuming a huge part of transfers of yet earned, realised, taxed profit, whose magnitude is over a billion euro per annum only in Hungary.

The Hungarian insurance industry changed very rapidly from being a wholly state owned, monopolised, centralised, plan-directed, nationalised, anachronistic, German speaking dominated quasi- or non-insurance regime to being 94% privately owned, totally decentralised, oligopolistic, more than 90 % foreign owned, open, relatively developed and German and Anglo Saxon dominated real competitive insurance market. The jump has been one from "Socialist Quasi Insurance" into the "21st Century insurance". Some examples:
- from a practically zero "life-portfolio" Hungary jumped not into the classical life or combined (mixed) policy period, but immediately in the time of unit linked,
- from a socialist industrial insurance Hungary didn't jump into the massive smallholder's insurance regime, but directly to multi-nationally decided professional industrial insurance,
- from a "not privately insured accident and illness" mentality Hungary moved not in the directions of the individual healthcare-contracting but stepped in the space of healthcare funds, or group insurance,
- from a monopolised "each city must have an office" approach Hungary turned not into the directions of a decentralised and strong network of offices but into the period of massive branch-closing as cost-saving, from an "agent and broker-free" insurance industry Hungary didn't move towards a system of classical "long-life" professional agency and brokerage but into the period of (life threatening) "only short-term turnover" mentality, etc.

The characteristics of this modern insurance industry are standardisation and binarisation. Standardisation is a practised methodology of product engineering based upon the "per-unit thinking of way": decomposition, creation and choice. Binarisation is a special form of standardisation where all potential questions of clients could and must be formulated only in two results: yes or no. Binarisation doesn’t equate to the simple computerisation but is linked to the "per-unit" and the "opportunity cost" approaches in relation to the pressure of cost-reductions and savings. To find the cheapest distribution network and back office cost-structure the binarisation seems the most appropriate tool because of relatively low personnel cost for training or hiring new employees and for protecting the agents and back-officers.

This "standardised" and "binarised" type of selling is day by day more popular on the Hungarian market. It has been started with travel-insurance, followed by unit linked and CASCO, last year achieved the flat & housing further the third part motor liability sector and dispersing and expanding today morning as well.

These "fast-educated" agents are supported by an emergency team of well-educated experts. They can easily turn to the selling of another product. They have not the task to take care for the more sophisticated clients. They are not in charge of the claim-settlement, which is centralised.

The common denominator in the historically irrational and extraordinary industrial and commercial success of the so-called low quality products is: standardisation, low cost, computerisation, outsourcing, cheap price, simple distribution, active marketing, etc.

Currently 30 to 40% of the Hungarian business is done using this approach. Within five years this could be 65%. Of course a qualitatively and better product line for high-middle-class population is needed. This is possible via assembling of existing standardised insurance products or via a combination of insurance with banking or security-linked products.

Continuous product engineering implies personalisation, enriching product-assortment, binarised selling and a unity for interactions. The consequences are that a small team of well-trained people in the regional branch offices could be sufficient. The branch-offices have to serve as a regional logistical centre for the simple standardised product selling and as the practical distributor for the more pretentious insured. In the headquarters' office people are obliged to fulfil the functions of
- permanent product designing,
- logistic and monitoring of ("fine") multifunctional products,
- partnership-maintenance or flexible and polite change,
- quick back-support as a "think tank" in case of "new" (i.e not yet "binarised") questions of agents, or regional teams,
- care and maintenance for all manuals and software at "standardised" products,
- leading the call centre,
- directing the regionally monitored claim-settlements,
- unified company PR, public "Message" and "Mission", etc.

The second session of the seminar was chaired by Morten Balling, Professor at the Aarhus School of Business in Denmark and member of the Council of Management of SUERF. Beate Reszat, Head of the International Financial Markets Research Programme of the Hamburg Institute of International Economics developed a historical view on "How has the European Monetary Integration Process contributed to Regional Financial Market Integration?"

The euromarkets can be regarded as the first step towards concentration and integration of financial activities in the European region that goes beyond the traditional foreign funding of domestic financial needs known in European trade at least since the Middle Ages. This process was entirely market-driven. Monetary authorities rather distrusted the markets as a potential source of instability and a source of financial liquidity outside their control. In their reliance on special techniques of risk sharing and risk reduction the euromarkets showed financial institutions the way how to act in an unfamiliar international environment coping with different systems and standards and, at the same time, made them become aware of the benefits of a market without borders. In this they created a climate in which future ideas of a convergence of rules and regulations, and the establishment of common institutions, would thrive.

Like the euromarkets European exchange rate policy contributed to creating the first building blocks of a common monetary and financial culture in Europe that paved the way for further integration and harmonisation. It was the first policy-driven effort, and the currency crises on its way demonstrated that the markets did not always agree with, or believe in, the results. Over the years, there was a growing understanding that, given the transaction volumes and the capacities to find leeways and leakages for circumvention, in order to be efficient, rules governing financial markets must either completely rule out market interference or leave a wide degree of flexibility and scope for market forces to find their own way. In Europe, in the realm of monetary policy, with the introduction of the common currency the first approach was chosen. In financial market development, for a long while the second one appeared more promising with the pendulum swinging back in the other direction only recently.

With the Big Bang in London the composition of actors in European markets changed opening up a new international dimension. For the first time in the financial history of Europe, institutions from other world regions began to compete with European ones in their domestic field on a large scale and on an equal footing. Beside, there was a rising awareness of the financial services sector as motor of economic growth and source of income and employment at a time when traditional industries in manufacturing were in decline. As a consequence, a fierce competition for financial business and the location of financial institutions started between European cities. These rose widespread expectations to markedly alter the financial landscape of Europe ending up in a state of concentration of financial activities in fewer places that would further promote the integration process.

Financial places in Europe built up the first linkages and networks long before official programs of financial and monetary integration came into force and managed to keep their position as hubs and spokes of regional and international financial activity or even widen it in recent years. So far, expectations that increasing competition would leave Europe's financial landscape reduced to fewer centres did not materialise. On the contrary, technological progress allowed smaller places to start competing with the big ones on an equal footing. Rivalry between financial centres enhanced financial integration, not through their decline in number but through the creation of strategic alliances and mergers beyond borders. The Single Market program sped up these developments.

The Single Market program has been the fifth major contributor to European integration. Full liberalisation of capital flows in the EU was reached in mid-1990. The integration process that followed was based on four principles: the harmonisation of standards, home country control and supervision, the provision of a single European passport for financial institutions, and mutual recognition. In the Single Market framework financial services are divided along functional lines focusing on the banking, securities and brokerage sectors. In addition, there were directives defining more specific subjects such as the solvency and own funds directives implementing the rules of the 1988 Basle Accord that called for minimum capital standards for internationally operating banks. In 1988, the EU launched the Financial Services Action Plan (FSAP) in an attempt to capitalise on the introduction of the euro.

FSAP components
Objective Subject areas
1. Single wholesale market - EU-wide capital rising
- Common legal framework for integrated securities and derivatives markets
- Uniform financial statements for listed companies
- Containing systemic risk in securities settlement
- Cross-border corporate restructuring
- Single market for investors
...
2. Open and secure retail markets - Distance selling of financial services
- Financial service providers' duty of information towards purchasers
- Cross-border payments
- E-commerce policy for financial services
...
3. Prudential rules and supervision - Reorganisation and winding-up of insurance undertakings and banks
- Disclosure of financial instruments
- Supervision of financial conglomerates
...
4. Wider conditions for an optimal single financial market - Harmonisation of tax regulations
- Creation of an efficient and transparent legal system of corporate governance
...

Experience so far has shown that the contribution of monetary integration to European financial integration differed across markets. The euro's catalyst role has been the stronger the more national markets have in common and the greater the importance of currency risk as discriminating factor. It has been most successful in the interbank market for very short-term unsecured deposits and in markets for bonds and derivatives where standardisation is comparably high. It played a lesser role for collateralised instruments and equities where differences in institutions and systems as well as cultural aspects impose additional barriers and hamper comparability. In general, influences accounting for heterogeneity can be grouped into five categories: maturities, liquidity, standardisation, transparency, third-market dependence and institutional differences.

The higher developed, more standardised and more liquid comparable financial instruments of different origin are, and the greater the degree of financial integration reached before, the stronger the effects of monetary integration and the introduction of a common currency. By contrast, imposing a single currency on immature, strongly specialised or highly fragmented markets may not only lower its effectiveness but also increase the likelihood of additional frictions. Examples are the uncertainties and search processes related to pricing processes in bond markets and the construction of yield curves in the euro area.

In national markets there is usually a strict hierarchy of borrowers determining the financial instruments serving as benchmarks. In the euro area, this relation is broken. It turned out that markets for national instruments are not deep and diverse enough to assume benchmark status for the whole region across all maturities. As a consequence price discovery has become more complex and widened to a larger circle of benchmark candidates including private borrowers and derivatives. Benchmark status is fraught with more risks and changing more frequently.

The effects of monetary union so far differed across markets and institutions. The biggest overall impact of the euro was on market volumes triggered by a shift from government to non-government securities, both short-term and long-term, as a consequence of the impact the Maastricht Treaty and the Stability and Growth Pact rules had on public finance. Another remarkable effect was the contribution of the common currency to the explosion of trading in instruments such as interest rate swaps and credit derivatives, and the need it created for developing new strategies and techniques for hedging and trading in the euro area.

But, beside these experiences the influence of the euro on financial integration in Europe is limited yet. Markets and systems are still highly fragmented and without the further removal of institutional barriers, and a greater commitment to financial reform and integration in EU countries at the level where individual measures are adopted, Europe's citizens are denied its full benefits. Cultural values, conventions and national interests are hard to harmonise. Just as an Austrian baker still needs eight licences to open a shop in Italy, a few kilometres down the road, despite 280 laws having been approved by European parliaments between 1986 and 1992 in order to create the single market, financial institutions cannot move freely across borders. In a sense, the Enron case has contributed more to strengthening and integrating European financial systems than the common currency in enhancing political commitment to reform and recalling the advantages Europe's financial systems have, despite the unquestionable differences between them: a traditional openness to the needs and requirements of an international financial community and a readiness to meet these needs by creating a respective environment and providing the rules for sound business.

Anders Grosen, Professor at the Aarhus School of Business presented a provocative paper on "The Crisis in the Danish Life Insurance and Pension Fund Companies". His paper describes the Danish life insurance and pension company crisis followed by the stock market downturn from mid 2000. The history of the crisis can be summarized into three headlines:
- It originates from the mid 1980s, where falling interest rates narrowed the differential between the market interest rates and guaranteed policy interest rates on issued contracts.
- It was hidden by the booming stock market of the 1990s.
- It has been repressed by companies together with the Danish FSA and government in the first years of this decade.

The causes of the Danish pension company crisis have been:
- The general level of interest rates has fallen over the last two decades.
- Taxation of pension funds since 1984.
- Stock market downturn since mid 2000.
- Mismanagement of interest rate guarantees and other embedded options issued with policies.
- Application of poor and inappropriate accounting principles.
- Lax accounting rules and regulatory forbearance.
- Moral hazard and legality problems have been a major factor in explaining the development of the crisis.

The responses to the crisis from authorities can be summarised as follows:
1) Regulatory authorities:
• EU: Third Life Insurance Directive (1992): Guaranteed interest rates cannot exceed 60 % of the rate of return on government bonds.
• Danish FSA:
- Maximum guaranteed interest rate is cut from 4.5% to 2.5% in July 1994 and again in January 1999 to 1.5%.
- FSA defined interest rate parameter to calculate accounting value of liabilities (technical provisions) from 1999.
- Introduction of "yellow and red alert" system-stress tests (2000).
- New accounting system (2002).

2) Government:
• 1998-2000: Changes in taxation towards more favourable treatment of bond returns – current tax rate is 15%.

The responses from the companies were
a) Responses concerning new products:
• Interest rate guarantees were lowered from 4.5% to 2.5% in 1994 and again to 1.5% in 1999.
• Change the type of option embedded from American to European type.
b) Responses concerning existing contracts:
• Outright denial of the concept of interest rate guarantees and that such a guarantee has ever been issued from the life insurers themselves.
• Invention of the conditional bonus.
c) ALM has been improved e.g. hedging of financial risk.
d) Political pressure for:
• Tax reductions.
• Company-inspired new accounting rules.

The lessons that can be drawn from the crisis are that:
- Interest rate guarantees and other embedded options on both sides of the balance sheet should be taken into account.
- It is dangerous to increase the stock-part of the portfolio as a response to the interest rate squeeze between market interest rates and the issued guarantees, as it will result in higher value of the embedded options.
- Fair value accounting system should be implemented.
- Authorities should resist political pressure for lax accounting rules and regulatory forbearance.
- Authorities should liquidate life insurers with solvency problems according to the rules made for the purpose.
- Authorities should implement more prudent capital requirement rules related to the quality of assets and liabilities.

Thomas Url of the Austrian Institute of Economic Research intervened as discussant for the papers of Beate Reszat and Anders Grosen. He agreed with Beate Reszat on the small impact of the EMU on financial market integration. Is the stability and growth pact a real market driver? Is higher efficiency of the financial markets a boost for more growth, more savings or more investments? What is the risk of inefficiency and the potential of fragmented markets? Are mega institutions the best answer?

According to the paper of Anders Grosen he stressed the characteristics of disinflation. Debtors are losers if inflation expectations decrease. He considers that a change in the taxation of pension funds is unacceptable. A life insurance contract must be decomposed into a prepaid part and an option linked to underlying assets. The value of surrender options is small because the exit fees are so high. There is always underestimation of the impact of the options, but an overestimation of the expected nominal return. The mismatch is due to a higher equity market exposure. The basic problem is probably that the Financial Service Agency has been too optimistic or followed a wishful thinking policy while the government reacted in a panic way.

In the third part of his intervention Thomas Url developed some views on the insurance business for insurance companies in Central Europe. The question arose of what is the optimal size? Big insurance companies are not particularly efficient, with approximately 20 % of them being too big. Outsourcing is a possible solution, as is developing the company’s business in underdeveloped markets. Austrian companies’ market share in Eastern European countries is more than 13 %.

The afternoon session was chaired by Jürgen Pfister, Senior Vice President of the Bayerische Landesbank and Vice President of SUERF. Othmar Ederer, the President of the Executive Committee of GRAWE developed his company’s shift "From Regional Insurance Company to Cross-border Financial Service Provider" in his intervention. GRAWE is active in insurance and financial services via its co-operation with four regional banks: HYPO Alpe-Adria-Bank, Raiffeisenlandesbank Steiermark, Capital Bank and S Security and Real Estate. GRAWE is present in Slovenia, Croatia, Hungary, Yugoslavia, Bosnia-Herzegovina, Bulgaria, Rumania, Ukraine and Moldova. GRAWE is a mutual company paying no dividends, with a far higher solvency ratio than the Austrian market average. Business has grown constantly in recent years.

The company’s international development since the end of the eighties has been closely linked to the growing co-operation between banks and insurance companies and to the opening of the borders to neighbours in the South and East, which has offered the chance to return to the pre-1918 situation. Othmar Ederer used the former Yugoslavian republics to describe how GRAWE‘s internationalisation began. Initially there was a predominance of the planned economy with monopolistic structures, with mainly state-owned insurance companies. There was a lack of legal regulations. In some cases there was a kind of compulsory insurance: third party liability and accident insurance for employees and group life insurance for companies. Virtual asset valuation methods meant over-valued balance sheets and profit and loss accounts. The opportunities offered: change of the political system, common historical roots, close distance, great market potential and little competition. The GRAWE's starting position was:
- Strong historical roots – GRAWE was the first insurance company in Inner Austria (Styria, Carinthia, Carniola) – established in 1828.
- The national border is within 45 km of the GRAWE’s head office.
- Yugoslavia was the second Eastern country to admit foreign insurance companies.
- Each of the 6 republics had its own quasi-monopolistic company, serving 23 million citizens in total.

There were three possibilities for market entry: firstly, a stake in an existing insurance company. This was quite impossible because the owners were unknown. The second was the creation of a new company in co-operation with a national insurance partner. The third possibility was the creation of a new company in co-operation with partners outside the insurance sector. In Yugoslavia there was an extreme North-to-South differential, as well as widespread reluctance concerning life insurance products offered by monopolistic companies. Insurance business had a bad image.

The immediate actions were to recruit staff, train sales personnel and to install a computer network. The major challenges were the fact that the economic development was unable to keep pace with the political changes, lack of staff, inadequate legal security, and the lack of telecommunication facilities.

The three pillars of GRAWE's strategy:
- Product range: adapting highly developed Austrian life and non-life insurance products to local requirements.
- Process of internationalisation: gaining experience in foreign markets and step-by-step expansion of international business activities (Uppsala model).
- Distribution: region-wide distribution through independent brokers and other sales channels, agencies, employed field staff.

Starting from zero, GRAWE has attained the following market position in the former Yugoslavia: 1.76% market share in Slovenia, 5.4% in Hungary, 1.74% in Bosnia-Herzegovina, 0.3% in Yugoslavia.

The present situation is characterised by:
- Still underdeveloped insurance markets, providing a great market potential.
- Since the transformation crisis in the nineties, the insurance industry has rapidly gained importance.
- The first phase of market consolidation is over (1999-2001).
- Reduction of state monopolies, liberalisation of market entry possibilities for foreign insurers.
- Fast adopting of EU standards.
- Accuracy of the balance sheet information after adjustment of the accounting standards.

EU enlargement offers the potential for a further liberalisation of the market entry for foreign insurers and a strong economic growth potential (on average 4.5 %). Of course, EU Directives concerning the insurance sector create a free market access for foreigners, guarantee the freedom of services, even without having to set up a branch office in the country, install a solvency control, define a minimum of requirements concerning the capitalisation of insurance companies and abolish the state monopolies.

The expectations for further development of the insurance business in that region are strongly due to the very low level of premiums in percentage of GDP, fluctuating between 0.7 % (Rumania) and 4.8% (Slovenia), while in Austria it is 5,9 %. There is also the evidence that demand for life and non-life insurance products increases disproportionately to the level of affluence. Southeast Europe is still adjusting itself to the new conditions and this phase will continue until 2009/2010. From 2005 onwards, another market consolidation phase will start to reduce the number of providers whilst intensifying competition between the large groups. A consolidation of distribution channels will follow, with a stronger focus on commission systems. Average growth will reach 10%. The market share of state insurers will decline. Cost advantages for foreign insurers will decrease, shifting the focus on claim settlement and administrative costs.

Már Gudmundsson, Chief Economist of the Central Bank of Iceland, presented a paper on "Pension reform and opportunities for insurance companies". His starting point was the presentation of the three-pillar pension system with each pillar’s particularities. Three pillars are necessary to accommodate the trade-offs between goals, to make the system more resilient to different types and to provide flexibility and choice.

Pension reforms in many European countries can be divided into two categories. So called parametric reforms include raising the retirement age, reducing the incentives for early retirement, increasing contributions and the contribution period, changing the indexation rule and changing the reference period for the calculation of benefits. Paradigmatic reforms involve introducing new alternatives like mandatory defined contribution funds with a choice of providers in the second pillar or a major boost to the third pillar with new legislation on tax incentives. A major shift from pay-as-you-go to funding, or from defined benefit to defined contribution, would also be examples of it.

In absolute terms, the UK is the biggest market in Europe for pension assets, followed by the Netherlands and Switzerland, with the Netherlands and Switzerland bigger in relation to GDP. They are also the leaders in terms of second pillar pension assets as a percentage of GDP. The biggest insurance market is the UK, followed by Germany and France. In terms of percentage of GDP, the UK is still leader if Luxembourg is excluded, followed by Ireland and Switzerland.

The Icelandic pension system has a public pension scheme from the age of 67. The basic pension amounts to 15% of average earnings of unskilled workers, but with the supplementary pension the total pension can go up to 70%. It is mandatory by law to pay at least 10% of all wages and salaries into fully-funded pension schemes. Occupational pension fund membership has been compulsory since 1974. The 10% contribution is split 40:60 between the employee and the employer, with the employee’s part being fully deductible from taxable income. There are 52 pension funds, the 10 largest having 70% of the net assets of all funds. Operational costs are only 0.1% of assets and 1% of contributions. Pension fund assets equate to 80% of GDP, putting Iceland in fourth place within the OECD behind the Netherlands, Switzerland and the UK. These assets are forecast to double in % GDP terms in the next three decades. Voluntary private pension saving has been stimulated by tax incentives. Third-pillar pension assets have reached 7.5% of GDP at the end of 2002.

The strengths of the Icelandic pension system are its complete coverage, full funding of the second pillar, neutrality vis-à-vis the retirement decision and the hybrid nature of the occupational pension funds. This has a beneficial effect on the labour market and on the financial system. The weaknesses are the different benefit level in the funds of investment returns diverge, the difficulty to choose a pension fund freely, because the funds are not actuarially fair as far as benefit accumulation is concerned. The contributions of the young generate the same benefits as those of the older members. Finally, disability pensions are also provided by the pension funds but have proved to be problematic for them.

The main lessons to be considered for others from the Icelandic experience:
- The prototype three-pillar system can be implemented and actually produces many of the promised beneficial effects.
- Significant funding of the pension system is beneficial, especially for small open economies.
- Pension systems can be designed in such a way as not to give undue incentives for early retirement.
- Hybrid pension plans between DC and DB are possible and should be considered along with other options.

Opportunities for insurance companies are biggest in the pension system’s third pillar. They can and do also make a significant business in the second pillar as insurers of liabilities, as fund managers, sellers of annuities and providers of pension plans in mandatory systems with choice. As a general rule, there is not a negative relationship between the size of the life insurance market and second pillar pension funds. But where occupational pension funds with in-house management are predominant, they might crowd-out life insurance companies, as demonstrated by Iceland. Generally, pension reform creates more opportunities for insurance companies as it tends to reduce the first pillar and create more scope for private provisions. Furthermore, it tends to promote DC, more choice and competition. It is another issue whether insurance companies find the risk-reward combination favourable enough to take up these opportunities.

Anne-Marie Gulde and Holger C. Wolf, of the IMF and Georgetown University respectively, focused their intervention on "Banking and Insurance Supervision in the Eurozone: Evolution versus Revolution". Their starting point is the complexity of the institutional and regulatory framework for financial stability in Europe due to the division of responsibilities between national governments, the EU and the ECB. The following table gives an overview of the actual supervision in EU countries.

Institutional Arrangements for Financial Market Supervision in EU Countries (*)

(*) B, I, S – Banking, Insurance and Securities supervision. Italics identify countries in which the national central bank remains fully or partially responsible for banking supervision.

The changing playing field has elicited responses. Within the EU, more than 100 M&A deals have been registered annually since 1997. About a quarter of all deals undertaken by institutions located in the EU now involve an institution located in another EEA member state, with almost another third involving an institution located outside the EEA.

The insurance sector is even more heterogeneous than the banking sector. Among important differentiating factors are the tax treatments of life insurance products and their resulting importance as a savings vehicle; as well as the asset composition and resulting exposure to equity and bond market developments. Nonetheless, the insurance and banking sectors also share many features, notably a co-existence of a large number of smaller national players and a few bulge-bracket institutions operating in multiple markets.

While the market for inter-bank loans is effectively integrated on the EMU level, substantial country effects remain in several other areas of business, including fees, other costs and corporate taxation. There is also substantial evidence that loans to the private sector retain a strong local flavour, a feature well known from the US market.

Looking forward, the process of financial integration, while varied and at times halting, is likely to continue, posing challenges to regulators and supervisors. The traditional approach of allocating regulatory and supervisory authority to the headquarter country has become problematic as some financial institutions headquartered in smaller economies conduct the lion's share of their business abroad. The separation between home and host markets raises informational problems, creates potential conflicts of interest and leads to a separation of the responsibility of the supervisory function (home country) and the responsibility for financial stability (host country). The same group of countries might find their lender of last resort (LoLR) capacity strained if locally headquartered banks encounter problems in larger foreign markets while both EMU and the GSP potential impose constraints on monetary and fiscal LoLR operations, raising the issue of the role of the ECB.

Many observers view a multilateral supervisory agency for at least the subset of pan-European banks or a "European System of Financial Supervisors" as appropriate over the longer horizon.

Beyond the challenges of day-to-day supervision, financial integration raises important issues for the structure of the crisis management framework. In the absence of a single EU-wide supervisor, crisis management must rely on a mixture of:
- differently structured national supervisory agencies,
- national central banks with sharply differing scopes for LoLR actions,
- national treasuries, some restrained by the Stability and Growth Pact, others more flexible,
- the ECB.
As integration proceeds, national supervisors and central banks may face increasing operational difficulties. The problem is most acute in the case of large banks headquartered in smaller economies, but also applies to multinational banks headquartered in larger markets. Beyond supervision, financial capacity may also be stretched.

Deposit insurance seems to provide the least cause for concern. However, only a few states have explicit insurance guarantee schemes in place. The lender-of-last-resort arrangements are set up nationally. Basel II and Solvency II rules are a major step in right direction. In order to avoid different national application new regulatory (level 2) and supervisory (level 3) committees have been created to develop common rules and ensure a consistent implementation.

During lively discussion after each session, the following topics were raised:
- Are financial markets really efficient enough to evaluate insurance companies correctly?
- Is Solvency II, which starts in 2009, still valid, when taking into account the substantial market shifts in recent years? The insurance sector is in favour of a quick implementation. The complexity of insurance products is greater than for bank products: duration, quality, guarantee, and life versus non-life.
- Is the Lamfalussy approach the best for banking and insurance? Can market-oriented supervisors work? Is a single model possible?
- What is the future of inflation-linked bonds in a period of sharp inflation decline?
- Is the real return more important than the nominal return for the savers?
- The exchange risks for pension funds investing in foreign markets.
- The need for a life insurance protection compared to the deposit insurance.

David Llewellyn expressed in his concluding remarks that insurance business developments are crucial for the coming years. Life insurance companies are extremely vulnerable. The subject must be discussed in the near future within other SUERF events. He thanked GRAWE, the Oesterreichische National Bank and the Austrian Society for Bank Research for their collaboration in organising this seminar.